An Important Aspect of Risk Tolerance: Ensuring that a Client Can Financially Sustain the Risk

As a financial advisor, I’ve been working for over twenty years in helping my clients at Comeau Financial build and preserve their wealth. In my career, I’ve seen the financial market enjoy its highs and suffer its lows; I’ve seen both bull and bear markets; and I’ve seen the financial sector absorb and withstand one of its largest downturns – namely, the financial meltdown of 2008 and the recession that’s followed it. Having experienced and worked in all these varying financial climates, I’d like to think that I’ve gained a strong understanding in how to advise my clients in a way that best suits their financial well-being. More specifically, I’d like to think that my experience as an advisor has enabled me to be even more adroit in accurately discerning my client’s willingness to take on financial risk.

Those of us who work in the financial and investment sector, and undoubtedly plenty of people outside the industry, know that financial risk is at the heart of making an investment. Simply put, regardless of what type of financial investment one is making or what type of economic environment the investment is being made in, an investment can never lead to a financial gain without the assumption of a certain amount of risk. The concept stands fundamentally at what it means to “invest” one’s assets.

Of course, it’s our duty as financial advisors to have a full understanding of the risks associated with each type of investment we advise on. More to the point of this article, in financially advising a client and helping build his or her financial portfolio, it’s part of a financial advisor’s duty to understand how much risk that client is willing to take on, or, to use industry language, it’s critical to understand that client’s “risk tolerance”. The capacity for an advisor to determine a client’s risk tolerance is indeed so crucial that I would argue that whether or not the advisor is skilled in this ability largely determines whether that financial advisor is a good one or not.

For this reason, I thought it would be worthwhile to discuss the subject of a client’s risk tolerance a little more extensively and, specifically, one aspect of it that I feel sometimes gets overlooked – namely, the client’s financial ability to withstand a risk, if indeed market environments turn negative and that risk turns into a reality.

In my years as a financial advisor, I’ve come to find that there’s a large and common difference between perceived risk versus risk capacity. When I approach a client with a new investment idea and I explain to them the risks associated with it, it’s common for the client to absorb what I’m telling them through the admittedly narrow framework of their own financial goals and their own portfolio. This is the client’s perceived risk and I’ve found that in many ways this can be dangerous and can lead to a myopic point of view on the part of the client.

Obviously, if a client understands an investment only from the perspective of how it will affect them and doesn’t understand, more broadly, how the investment interacts with the greater financial world, this is not a good thing. It’s for this reason that I take pains to explain to the client two additional elements of any investment: one, the greater or required risk associated with the investment and, second, the client’s real financial ability to withstand the risk if the market happens to face a downturn.

Of course, there’s always the danger of information overload. Many clients that financial advisors help are individuals who do not work on a daily basis with investments and finances and who may not be very well-versed in all the terms of the industry. So, in describing an investment, it’s important not to overwhelm clients with too much technical detail. However, that gives no excuse for not providing clients with enough information that they can’t understand the required risk that goes along with an investment, as well as how it relates to their risk capacity – that’s a fundamental part of being an honest and fair advisor.